Five years and counting

Do foreign small-cap stocks have more run in them?

(Editors note: This update corrects the spelling of the name of SunAmerica fund manager Hans Danielsson)

LOS ANGELES (MarketWatch) -- For international small-cap-stock investors, good times really have never seemed so good. And while fund managers aren't expecting the bottom to drop out any time soon, they don't expect a repeat of some of the best years either.

Then again, cautious optimism has pretty much accompanied the sector throughout the last few years of its more-than five-year winning streak.

Funds dedicated to the growth side of foreign small-cap and midcap stocks have returned an annualized 23.7% over five years, according to Morningstar, Inc. On the value side, foreign small-cap and midcap stocks are up 22% over that time. That beats the U.S. small-cap sectors, where small-cap growth is up an annualized 11.25% over five years and the small-blend category is up 13.76%.

"It's very hard to predict whether a rally will continue or not. It's definitely a good idea for people to realize that anytime a category has been on a run as foreign small/mid-caps have been, they should not expect that level of return to continue indefinitely," said Gregg Wolper, senior analyst with Morningstar.

That's not to say that the rally can't keep going and investors can't get "solid results" from the sector, he said. "You just need to keep your expectations in check and not expect 30% every year, just because that's what you have got the past few years."

'You need to keep your expectations in check and not expect 30% (returns) every year, just because that's what you have got in the past few years.'
Gregg Wolper, senior analyst with Morningstar.

He said investors should also remember that just because international markets seem more tied together, that "doesn't mean all companies and markets move up and down together."

Small-cap managers will be the first to say that they are among the best at spreading risk around because their portfolios contain lots of small companies dealing in many different industries, offering plenty of diversity.

Joe Rivello, executive vice president of international equities at J. Giordano Securities Group, said where large caps are benefiting from mergers and acquisitions, small caps are performing well due to business fundamentals. Rivello's company provides research on 300 international small companies to fund managers and institutions.

He said a major theme for the sector is global growth. "The wealth effect has been so strong that smaller companies are most leveraged to these improving economies and that has fueled earnings growth in these companies, and also fueled valuations as well as earnings growth momentum and surprises," said Rivello.

And while market caps of smaller foreign companies are low relative to the size of U.S. small-cap companies "the profitabilities of the foreign companies are quite large relative to share-price performance," he said.

Specifically, he's seeing that situation play out in Turkey, the U.K., France and Poland. Among the companies on his radar is W. Kruk Sp, a Polish luxury-goods company, which has returned around 120.7% year to date. "Its performance has a lot to do with the underlying fundamentals of the business," he said.

Another example, he said, is Greece-based Michaniki SA. "They're not only in the building sector, but are moving into real estate. It's been a very hot game. That's the reason why this stock is up 72% year to date," said Rivello.

Plenty of smaller choices

Randy Farina, co-portfolio manager of Putnam International Capital Opportunities
PNVAX, -0.05%
said international small-cap stocks have had similar levels of risk over the last 10 years to U.S. large caps, and have been less risky than U.S. small-cap stocks.

"Historically (over the last 10 years), the risk of these two asset classes have been the same and looking into the future valuation and quality of these two asset classes, there's no bet to be made against either asset class -- no valuation or quality discrepancy."

He noted that international small caps are much cheaper than their U.S. counterparts and have produced much higher returns on equity.

But he said investors shouldn't get stuck looking at past earnings when it comes to international small-cap companies. "Always use valuation and quality as your guide ... U.S. small caps have today done extremely well, and small-cap international has also done extremely well, but valuation there is not stretched."

He said his fund is finding plenty of "cheap, high-quality companies." Japan stocks make up a third of the portfolio, with 20% in the U.K. and 7% each allocated to Canada, Germany and France. Among his picks: Japan's Pacific Metals Co. (5541), which coats stainless steel and is benefiting from China growth, Aur Resources Inc. (AUR), a Canadian basic materials play, U.K.-based mortgage bank Northern Rock (NRK) and Brother Industries (6448) of Japan, which makes copiers, printers and sewing machines.

Federico Laffan, vice president and portfolio manager of American Century International Opportunities
AIOIX, +0.09%
said he faces the same issues when looking for new ideas for his portfolio -- an abundance of choices rather than a lack of companies.

"The problem we do have is the market questions the sustainability of the growth that we're seeing. From a bottom-up perspective, you may look at a stock, make an investment, and it's growing and improving and looks great. The next day, inflation or payroll out of the U.S. is worse than expected and my stocks get hit."

"Any bad news out of the U.S. is bad news for companies anywhere in the world, particularly cyclical industries," said Laffan.

Holding back, just a little

Hans Danielsson, one of the portfolio managers for the SunAmerica International Small Cap Fund
SAESX, +0.35%
said he wouldn't exactly advise investors to overweight foreign small caps after such a lengthy period of outperformance. Still, he said, "I'm a believer in the upward direction of the equity markets and the global bull cycle has some time left to go. We think this fund will deliver positive returns in a meaningful magnitude over the next year or so, better than large-cap returns."

The reasons for that are two-fold, partly cyclical, but also structural, he said. "One is globalization where with smaller companies it's all new for them. Big S&P 500 stocks have been global in their outlook for decades, but that's not really the case for small companies in Europe and in Asia. They are just starting or just started to benefit from going abroad in a major, major way."

As for where investors can invest, it's no secret that many of the best international small-cap funds are closed. The funds start out smaller than their large-cap companions and fill up faster. Morningstar recently pointed out three funds that are still open: T. Rowe Price International Discovery
PRIDX, -0.01%
Polaris Global Value
PGVFX, +0.32%
and Hartford International Small Company (if you invest through a full-service broker)
HNSAX, +0.29%

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